Value stocks: when cheaper isn’t cheap enough

“Value versus growth” is one of the easiest frames through which we can look at investing styles. Yes, it is a simplistic divide (see below): no investor can ignore valuations nor how earnings are likely to evolve. But it still says something about the psychology of an investor: do you favour a solid chance of profits today or the riskier possibility of a bigger gain in the future?

Splitting markets into growth and value also shines a useful light on trends. The MSCI World Growth index has beaten its value counterpart by six percentage points per year over the past decade, which is remarkable, but by more than sixteen points per year over the past three years, which is barely believable. With the growth index now on a forecast price/earnings of almost 30, compared with 13 for value, it’s hard to see how that can be repeated.

Investors want excitement

Value against growth is not the only long-standing anomaly to struggle lately. History also suggests that stocks with lower share-price volatility tend to outperform more volatile ones on average, yet the S&P 500 Low Volatility index (which holds the 100 least volatile stocks in the main US benchmark) has lagged the S&P 500 by 3.5 percentage points per year over ten years and almost ten percentage points per year over the past three years. No matter how you break it down, you can see the preference for glamorous, volatile growth stocks over anything duller.

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Yet neither value nor low volatility have performed badly in absolute terms. The World Value index has returned an acceptable 9%-10% per year over three, five and ten years. The S&P 500 Low Volatility has returned 15% per year over three years and 12%-13% over five to ten years. This makes it hard to be confident that we can expect value stocks or low-volatility stocks to do well in absolute terms when the environment changes, because in many cases they have not done worse than expected up to now – they’ve simply been outstripped by a boom in growth.

In particular, much of the return from value stocks usually comes from improving valuations as investors become less negative about their prospects, not through growth or increased profitability (see the chart above from Verdad Capital, which shows that about two-thirds of the total return in US value over the last 25 years came from changes in valuations). Today, value is not especially cheap in absolute terms, even if it is relatively cheap compared with growth. That will make it harder to benefit from the tailwind of improving valuations. Thus while value – and low volatility – will probably do better relative to growth, only a few genuinely unloved sectors (perhaps oil) seem likely to deliver impressive absolute returns.

The difference between growth stocks and value stocks

Investors in stocks can follow a number of distinctively different approaches – often referred to as styles – when deciding which companies to buy. The two styles that are most frequently used to classify investors are growth and value.

Growth investors look for companies that are expected to grow their earnings faster than their sector or the wider market. They will often be willing to buy shares on valuations that appear quite high compared to other companies if they believe that these may be justified by future profits. This approach places more emphasis on the firm’s potential, as opposed to its current financial situation.

Value investing is the opposite. Value investors focus on companies that appear to be cheap today (or sometimes stocks that should be cheap in the very near future if the business recovers after a recession or crisis). While growth investors are typically mostly concerned with earnings, value investors will often look for stocks that trade at a discount to book value (assets minus liabilities) or offer high dividend yields.

Some investors view the distinction between growth and value as artificial. A successful growth investor still needs to be confident that a company is not so overvalued that its earnings can’t justify the price they are paying. A value investor needs to consider whether a stock is cheap because the underlying fundamentals of the business are faltering and will lead to reduced profits, financial distress or bankruptcy in future.

That said, growth versus value provides an easy way to divide the market into stocks that are popular and high-priced and those that are out of favour and trade on lower valuations. Historically, the value segment of most markets have tended to beat the growth segment over the long run (which may be attributed to exuberant investors overvaluing potential growth). However, in the past decade, growth has handily beaten value.